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August 2012

08/25/2012

Delaware dominates the corporate charter business. About 60% of Fortune 500 firms incorporate in Delaware as has been well documented. And Delaware’s dominance is not limited to large, blue-chip companies; most entrepreneurial ventures that secure professional outside financing are incorporated in Delaware as well. Over the years, Delaware’s incorporation monopoly has been challenged by several other states, but they have had only modest success.

The newest entrant in the “race” among the states is North Dakota, which enacted its Publicly Traded Corporations Act in 2007 in an attempt to offer a “shareholder-friendly” alternative to Delaware. The Act received a fair amount of attention from noted scholars and stimulated a flurry of shareholder proposals to reincorporate there in the 2009 proxy season. But as Stephen Bainbridge predicted and then reiterated, the initiative failed to attract a significant number of companies from Delaware. Even the shareholder proposals seem to have dried up, with no proposals in the 2011 proxy season.

Why did the North Dakota experiment fail? Bainbridge predicted companies would not reincorporate in North Dakota for three primary reasons (loosely paraphrased): (1) Delaware’s case law and courts allow “legal questions to be answered with confidence,” something that would take North Dakota years to achieve, (2) management has no reason to reincorporate there if the race is to the bottom, and (3) nobody has in incentive to reincorporate there if the race is to the top.

I agree with Bainbridge’s basic reasons for why North Dakota’s law failed but disagree about the inevitability of Delaware’s dominance. North Dakota failed because its approach failed to offer a Pareto superior alternative to the Delaware status quo. The problem with a state merely offering a “shareholder friendly” alternative is that shareholders do not have the power to initiate a reincorporation. This means, as Lucian Bebchuk has pointed out (p. 862), it is very difficult to change when managers favor the status quo—Delaware. If a state is to seriously challenge Delaware (absent federal intervention), it will need to offer an advantage that appeals to management as well as shareholders—in other words, a Pareto superior alternative to Delaware.

I believe there is exactly such a Pareto superior opportunity that has gone unnoticed by challenging states like Nevada and North Dakota. There is one thing that both mangers and shareholders want that Delaware does not provide—ex ante certainty about basic corporate law questions. Although Delaware is often praised for its predictable corporate law, it turns out that innumerable basic, foundational corporate law questions are still completely uncertain in Delaware. To illustrate this, I performed a search in Delaware corporate cases decided since 2005 for issues described as being “of first impression” by the court itself and found (among others) these:

Do officers have the same fiduciary duties as directors? Gantler v. Stephens (2009).

Can preferred stock be created with no right to receive dividends? Shintom v. Audiovox (2005).

What happens when a fiduciary fails to observe its duty of full disclosure? Berger v. Pubco (2009).

What is a promoter's liability in connection with a preincorporation agreement? Re: GS Petroleum, Inc. v. R and S Fuel (2009).

Are employment contracts containing restrictive covenants are assignable in a sale of the business? Great American Opportunities v. Cherrydale Fundraising (2010).

These are not obscure interstitial details or rapidly-evolving, cutting edge issues. These are basic questions in stable, even hoary areas of law that should have been resolved clearly and definitively decades ago. I do not mean to suggest that other states do a better job that Delaware at clarifying corporate law rules; they don’t. Other states have all of these types of enduring and perplexing uncertainties, and more. The point is that the law is unclear everywhere because of the maddeningly inefficient tradition of making corporate law decisions through judge-made law. But is that inevitable?

The answer is “no,” because there is an obvious alternative no state has tried. A state like North Dakota could provide more certainty than Delaware simply by taking the monopoly on answers away from the litigators and opening it up to planners. A rival state should create a system for providing reliable answers in advance of litigation—indeed, in advance of corporate action—by allowing its companies to simply ask for authoritative answers to basic questions such as whether preferred stock must pay dividends, by asking in advance of taking action, rather than by litigating after taking action. This is the type of guidance that is common in tax, bank regulation, securities regulation, and other areas that require advance planning, but is strangely absent in corporate law. Whether the ex ante guidance took the form of advisory opinions from a court or interpretive guidance from an administrative agency, the state that established such a mechanism to provide managers with authoritative answers ahead of time about uncertain questions of law would lure managers away from Delaware, shareholder friendly or not.

In this approach, a state would set up an authoritative body, which could consist of a business court or an administrative agency, that would receive and act upon confidential requests for interpretive guidance. Instead of paying Delaware counsel hundreds of thousands of dollars for uncertain predictions about the inclination of their friends on the Court of Chancery, a North Dakota agency could answer the question definitively, with certainty, and most importantly, before a decision had to be made. Other states would have to yield to North Dakota’s interpretation of its own corporate law under the Supreme Court’s interpretation of the internal affairs doctrine, which means that companies would be completely protected by such an interpretation. Thus, managers could proceed with routine transactions without the nagging uncertainty of litigation, and shareholders would be immunized from the destructive activity of nuisance plaintiffs.

Suppose a state implemented this suggestion and was successful in attracting companies away from Delaware. Why wouldn’t Delaware just adopt the innovation and outcompete the upstart state? That is the essence of Bainbridge’s final argument, “if investors valued the provisions of the North Dakota Act, Delaware would have gotten there first.” Yet Delaware could not follow where North Dakota could lead, and this is the key to the understanding why this proposal would work.

Delaware has no incentive to provide ex ante answers to legal problems, either as a first-mover or in response to another state. Why? Because Delaware’s advantage in the corporate charter business is also its vulnerability. The Delaware bar’s entrenched interest depends on the ex post revelation of corporate law answers through constant litigation and adjudication. The demand for members of the Delaware bar is driven by the uncertainty, ambiguity, and confusion created by the reliance on judge-made law. Only Delaware lawyers are able to provide companies the best advice based on off-the record conversations with their friends on the bench. Delaware’s wealth is in its human capital: its bench and its bar. But these informal networks of influence and social advantages are no longer valuable when authoritative answers can be had in advance from another state.

In future posts, I plan to build out this proposal for how a small state could make a big impact on corporate law in the United States. In the mean time, I'll wait for a call from North Dakota.

08/15/2012

The last post used computer analysis contracts from the SEC’s EDGAR database and Google Ngrams to create the top-25 list of legal jargon words. The definition used for legal jargon was how much more frequently individual words appear in legal documents (represented by EDGAR contracts) than in ordinary writing (represented by Google Books).

The legal jargon exercise triggered an idea. What about all that non-legal jargon? What are the words that are used frequently in Google Books but rarely used in contracts? For this task, I took the reciprocal of the score computed in the last post to come up with this top-25 list of non-legal jargon words.

1

slowly

56785.4

2

thoughts

51401.5

3

deeply

49863.5

4

struggle

48615.3

5

perfectly

46897.3

6

everywhere

44875.3

7

really

44824.1

8

somewhere

44437.4

9

convinced

43454.3

10

man's

42893.4

11

watching

42849.3

12

phenomenon

40939.7

13

looked

40052.7

14

hide

38844.2

15

legs

38598.1

16

isn't

38292

17

perhaps

37857.4

18

plenty

37090.4

19

fears

36324.5

20

nice

35880.4

21

ears

35848.6

22

dressed

35773.6

23

tiny

35302.8

24

anxious

35047.2

25

nervous

34232.2

The corresponding Wordle for the non-legal jargon is below:

I suppose it’s obvious why drafters don’t use words like “anxious," “nervous," and "cruel" very much in contracts. It’s difficult to imagine a reason to use those words unless we decide to adopt a cathartic or expressive style of contract someday. The full set of 1000 results, available here, contains some more colorful results.

Perhaps one of the most interesting aspects of the results above and the top 1000 results here is the almost complete absence of contractions from contract drafting (and therefore presence of contractions on this list). As discussed in the last post, the words used in contracts tend to follow a certain style, which legal drafting “experts” call “archaic” and I call “stable.” Legal writing experts have a particular antipathy towards distinctly legal styles of expression in contracts. Thus, one suspects it’s only a matter of time before legal drafting experts are promoting the use of contractions in agreements. This could manifest itself in amusingly archaic ways, given the prominence of “shall” in contracts. Perhaps the countercurrents of old and new could produce a revival of the word “shan’t.”

You might be thinking of a few words that are common in everyday speech but not represented here. In order for the word to be included, it must appear somewhere in both Google Ngrams and a contract from EDGAR. So although “asteroid” is reasonably common in Google Books, appearing in over 20,000 books, it doesn’t appear in any of the 13,957 contracts surveyed. Lest one believe that no contract drafter has ever thought to provide for the case of asteroids, that contingency does appear in the definition of “force majeure” together with “meteor” in this contract.

08/06/2012

Lawyers are notorious for legalese. Aside from venality, legalese is probably the most common fodder for lawyer jokes. The criticism of legalese is especially common in contract writing, where laypersons regularly lament the turgidity of legal boilerplate.

But it’s not just laypersons who chastise contract drafters for using obscure jargon. One of the most prominent legal writing experts, Brian Garner, has launched a crusade against legalese, even suggesting a “blacklist” of a “dirty dozen” words that lawyers should wipe from the face of the Earth (Garner on Language and Writing 2009, 180-184). Yes, WITNESSETH is on that list.

I decided to investigate the question of legalese empirically. A quick glance at the words legal writing experts seek to eliminate reveals that they have one thing in common: they are distinctively legal, meaning that lawyers use them and regular people don’t. Identifying such words is exactly the type of problem that data can help to solve. Perhaps I could find some words to add to the legalese blacklist.

To accomplish this important task, I (my computer, actually) collected 13,957 randomly selected contracts from SEC filing exhibits on EDGAR. EDGAR exhibits are one of the most easily accessible sources of contracts and are also among the most lawyer-intensive contracts, as they contain the agreements of publicly traded companies. These 13,957 contracts contained about 457,000 unique words, for a total of approximately 161 million words.

To find a measure of what regular (non-lawyer) people write, I downloaded all English n-grams from Google Books’ Ngram Viewer. Google’s (slightly more impressive) database contained about 1.2 million books with about 133 billion words. I limited my Google Ngrams to those contained in at least 1000 books and I used 1993-2009 counts to correspond best with the period in which the EDGAR filings are drawn. An Ngram is a single word.

I then computed ratios of how often each word was used in EDGAR contracts (lawyerly writers) to how often the word was used in Google Books (regular writers). I constructed four different models, each emphasizing to varying degrees overall word frequencies (the total proportion of times a word appears) versus number of contracts or books in which the word appears. I blended all of the ratios to construct a measure, which I will denote the “legalese ratio” roughly defined as:

I was disappointed with the showing of WITNESSETH in this list. WITNESSETH came in 13th, which is in the top 0.003% of legalese words, but I expected better. It would be hard to top “unstayed” or “sequestrator” in a legalese ranking, but losing out to “construed” was unexpected.

For visual learners, I used www.wordle.net to construct this highly scientific Wordle using the results:

The list of words and the Wordle show a definite bias toward securities dealmaking (e.g., “issuable” and “nonassessable” are first and second). But what are the general lessons about legalese? About half of the “dirty dozen” single words Garner has marked for extirpation are in the top 500.

The list shows rather clearly that some words are used frequently in legal agreements and almost never outside that context. But is that a reason to eliminate them from legal writing? Contracts are not supposed to be page-turners; books are. Indeed, ideally, nobody would have any reason to read a contract. Contracts are typically only read when a disagreement arises in a business relationship. And when there’s a disagreement, the contract’s aesthetic qualities tend to recede into the background. What matters is whether the functional qualities of the words, and that’s where legalese shines.

Taking shots at contractual language as antiquated or archaic is easy from the leisurely perspective of the scholarly writer. But real-life lawyers have to draft contracts fast, often overnight, and clients don’t want to pay for sparkling prose that (ideally) nobody will ever read. Garner says that eliminating legalese will allow the drafter to “feel as if [he or she is] making a difference in [his or her] own little niche of the world” (Garner p. 184).

But do clients want to rack up billable hours to help you feel that way? Of course they don’t. Imagine submitting an itemized bill to a client that listed several hours spent (at hundreds of dollars an hour) changing “issuable,” “unstayed,” “hereunder” and the like to more conversational terms. The client would fire the lawyer for that. Spending clients’ money changing legal terms to plain English would be exactly the type of billable hour “padding” that lawyers are often wrongly accused of. That’s why the persistence of legalese actually reflects much of what is good about the legal profession.

In the next post, I launch my own blacklist of words using the “inverse” reasoning.